How Will Hedge Funds Respond to a Dismal Year of Performance?

It can’t be sugarcoated. Hedge funds, for the third year running, have concluded another inauspicious year, not only in terms of gains, but also in the context of asset flows and industry growth.

Glaring Failures

Not to paint the industry with too broad a brush, it is important to begin by saying that the majority of hedge funds either were even, or had positive gains for 2016. It should also be noted that although 61 percent of hedge funds experienced redemptions, a significant percentage of these redeemed funds were reinvested with higher performing hedge funds. Lastly, while it is fact that hedge fund closures outpaced hedge fund starts for the first time since the financial crisis, the difference between starts and closures was not a large number.

However, looking at the industry as a whole, hedge funds underperformed the S&P 500, had net negative asset flows and closed more shops than they opened.

Does This Suggest an Industry in Decline?

Probably not, but it very well may signal a tipping point. It is time for the hedge fund industry to respond. Those hedge funds experiencing two or three years of break-even performance or worse will almost certainly be punished by investors.

Redemptions from underperforming funds will continue until these funds either turn around, or are driven out of business. This is not to say that overall hedge fund assets under management (AUM) will decline, although they may. Rather, it is more likely that funds redeemed from underperforming firms will shift to higher performing firms or firms with superior strategies. This will necessarily result in a shrinking number of hedge fund firms going forward. This is not necessarily a bad outcome.

What Is the Solution?

Too many hedge funds have lost sight of their core objective…preserve capital. In short, too many hedge funds don’t hedge. While there are many hedge fund managers that excel at picking stock or identifying cryptic correlation trades, too few are skilled at constructing balanced portfolios, true hedging and managing multifaceted risks.

Portfolio managers that have made fortunes on fundamental, momentum-based trading are now focusing on neutral long and neutral short strategies and quant funds, are investing capital to create a hybrid investment style.

What about Jobs?

These shifts in investment styles will create challenges for hedge funds—challenges that are not easily met with existing talent. As a result, hedge funds will likely step up the hiring of asset management talent with proven portfolio construction talent. Also in demand will be quant-equity and quant macro researchers. Demand for developers is also likely to increase.

In short, the prospects for employment in the hedge fund industry are promising, given the right experience and educational background. The hedge fund industry need only fear decline if hedge fund management fails to rise to today’s challenges.